Author: EduInvest Academy

Basic Principles of Fiscal & Monetary Policy

Infographic Courtesy by Federal Reserve Bank of Atlanta (All due credits)

What is RBI Monetary Policy?
Monetary policy is the macroeconomic policy laid down by the Reserve Bank of India. It involves the management of money supply and interest rates. The central bank tweaks interest rates to achieve macroeconomic objectives such as liquidity, consumption and inflation.

What are repo rate and reverse repo rate?
Repo rate is the rate at which RBI lends money to the commercial banks. The rate is used by monetary authorities to control inflation. On the other hand, reverse repo is the rate at which commercial banks park their money with the central bank. At present, repo rate and reverse repo rate stand at 5.15 per cent and 4.90 per cent, respectively.

When is RBI Monetary Policy?
RBI monetary policy committee will meet during February 4-6 for its sixth bi-monthly Monetary Policy Statement for 2019-20. The resolution of the MPC will be placed on the website at 11.45 AM on February 6, 2020.

The composition of the current and first monetary policy committee is as follows:

1. Governor of the Reserve Bank of India – Chairperson, ex officio – Shaktikanta Das
2. Deputy Governor of the Bank in charge of monetary policy — Michael Debrata Patra
3. Executive director of the Bank in charge of monetary policy — Dr. Janak Raj
4. Shri Chetan Ghate, Professor, Indian Statistical Institute (ISI) – Member;
5. Professor Pami Dua, Director, Delhi School of Economics – Member;
6. Dr. Ravindra H. Dholakia, Professor, Indian Institute of Management, Ahmedabad – Member

Members referred to at 4 to 6 above, will hold office for a period of four years from the date of appointment while the other three members are official. All the central government nominees are not eligible to be re-appointed.

Will RBI cut policy rates on February 6?
A Reuters poll of economists, conducted before Budget showed that the central bank is expected to keep the repo rate unchanged until at least October, when it is seen resuming its easing path. RBI is now forecast to next cut rates by 25 basis points to 4.90 per cent in the October-December quarter, though some analysts reckon the central bank will keep rates on hold for longer.

Courtesy of the Info graphic Visual Capitalist

This guest blog is contributed by our student Ms. Krina Shah.

We are welcoming all you budding finance professionals to come contribute your interesting articles about Economics, Finance, Stock Markets & more as a guest blogger on our Website!

Do write to use if you want to get featured here! So hurry up, happy writing, happy reading! – EduInvest Academy

IFRS 16 was issued in January 2016 and applies to annual reporting periods beginning on or after 1 January 2019. Under IFRS 16, there is no classification for operating leases and capital leases. There is only one umbrella for all leases – finance leases. Per the new rules, all leases must be accounted for on your balance sheet. Because your leases are no longer classified, you no longer need to use separate calculations – straight-lined vs. an outline of your interest and depreciation expense.

Under IFRS 16, all leases will be calculated using your interest expense and depreciation expense. Instead all recognised leases are treated in a similar way to finance leases applying IAS 17.

Following are the criteria for identification of Lease:

• The fact that a contract is labelled a lease does not necessarily mean it is or contains a lease.
• One of the key considerations is to evaluate whether the customer has the right to control the use of the identified asset. The control assessment is focused on decision-making rights.
  • Does the entity have the right to obtain substantially all the economic benefits from the use of the identified asset?
  • Does the entity have the right to direct the use of the identified asset?

An identified asset is an asset that is either explicitly identified in the contract or is implicitly specified by being identified at the time that the asset is made available for use by the customer. Even if an asset is explicitly specified, a customer does not have the right to use an identified asset if the supplier has a substantive substitution right throughout the period of use.

Can a portion of an asset be an identified asset?

Yes, a portion of an asset is an identified asset if it is physically distinct (example: a single floor of an apartment building). Where a portion of an asset is not physically distinct (example: 20% of the capacity of an oil pipeline), the portion of the asset is not an identified asset unless it represents substantially all of the capacity of the asset. If neither of these situations exist, the customer is not provided with the right to obtain substantially all the economic benefits from use of the asset and an identified asset does not exist.

For better understanding of the identification of lease we shall use following example:

Example 1 – Rail cars

In a contract between a customer and a supplier, the supplier needs to transport goods using a particular type of rail car in line with a specified timetable over a three-year period. The timetable and quantity of goods stipulated are equivalent to the customer having the use of six rail cars for three years. The supplier makes available the cars, driver and engines as part of the arrangement. The supplier has a large supply of similar cars and engines that are available to fulfil the obligations of the arrangement. The rail cars and engines are kept at the supplier’s premises when they are not being used to transport the goods.

Analysis of the above example

The contract does not contain a lease of either rail cars or engines. The rail cars and engines used to transport the customer’s goods are not identified assets. The supplier has a substantive substitution right to replace the rail cars and engines as a result of:

1. Supplier having the practical ability to substitute each car and engine throughout the period of use. Alternative cars and engines are readily available to the supplier and these can be substituted without the customer’s approval, and the supplier being able to economically benefit from substituting each car and engine. There would be very little cost associated
2. Substituting these assets as the cars and engines are stored at the supplier’s premises and the supplier has a large pool of similar cars and engines. Therefore, the customer does not have the right to obtain substantially all of the economic benefits from the use of an identified rail car or an engine or directs their use. The supplier chooses which rail cars and engines are used for each delivery and therefore direct them. It has substantially all of the economic benefits from use of the rail cars and engines.

As per the above example we understand whether the contract is a lease or not?

Now let’s understand what a lease term is, the lease term is defined as “the non-cancellable period for which a lease has the right to use an underlying asset, together with both:

1. Periods covered by an option to extent the lease if the lessee is reasonably certain to exercise that option; and
2. Periods covered by an option to terminate the lease if the lessee is reasonably certain not to exercise that option”.

A lease is no longer enforceable when the lessee and the lessor each has the right to terminate the lease without permission from the other party with no more than an insignificant penalty.

IFRS 16 has an exemption for leases that meet the definition of a short-term lease. Short-term lease defined as leases that, at the commencement date, have a lease term of 12 months or less. A lease that contains a purchase option cannot be a short-term lease. As we move forward, let’s understand what we really mean by Lease payments, following are the categories of lease payments:

1. They are Fixed payments, including in-substance fixed payments, less any lease incentives
2. Exercise price of a purchase option (if reasonably certain of exercise)
3. Payments for penalties for terminating the lease (unless reasonably certain not to exercise)
4. Variable lease payments that depend on an index or rate
5. Residual value guarantees (lessees: expected payment/lessors: all guarantees

*If the lessee is reasonably certain to exercise a purchase option, the exercise price is included as a lease payment.

Lease payments also include residual value guarantees.

For Example:

Lessee Z has entered into a lease contract with Lessor L to lease a car. The lease term is five years. In addition, Z and L agree on a residual value guarantee – if the fair value of the car at the end of the lease term is below 400, then Z will pay to L an amount equal to the difference between 400 and the fair value of the car. At commencement of the lease, Z expects the fair value of the car at the end of the lease term to be 400. Z therefore includes an amount of zero in the lease payments when calculating its lease liability. Subsequently, Z monitors the expected fair value of the car at the end of the lease term. If the expected fair value of the car falls below 400, then Z will remeasure the lease liability to include the amount expected to be payable under the residual value guarantee, using an unchanged discount rate.

Incremental Borrowing Rate:

The incremental borrowing rate is the rate of interest that a lessee would have to pay to borrow with a similar security over a similar term an amount equal to the lease payments in a similar economic environment. This definition implies that the incremental borrowing rate is not only a specific for the lessee, but also for the underlying asset and that’s the reason why you cannot use the same incremental borrowing rate for all of your leases.

Let me give a few illustrations:

1. Imagine you want to lease the valuable land in a high-level area – that’s really a great value collateral and it affects your incremental borrowing rate. But, if you would like to lease a car, that’s not so valuable collateral as the land. In other words, the security is not the same and you would need to apply different incremental borrowing rate when leasing a car and when leasing a land.
2. Imagine you want to lease a land for 1 mil. CU and a car for 20 000 CU – not the same level of risk for the bank as not the same amount of funds necessary to borrow.
3. Imagine your car leases are for 3 years, but the office lease is for 10 years. I am quite sure that the interest rate offered by the bank for 3-year loans would be different from the rate offered for 10- year loans.
4. Imagine you want to lease an office space in the capital city centre and a warehouse in a cheap area of your country. Again, not the same value, strength and environment.

So, how to determine the incremental borrowing rate

There are 2 basic steps:

1. Take some observable rate: Observable rates can be for example the rate on your past similar borrowings, or the actual offers from your bank for the loans with similar amount, security and term. Or, if you are renting the property, then the property yields could be a great start.
2. Make adjustments: Adjustment might be needed exactly because your observable rates might not precisely reflect the lease

For example, when you take the rates for unsecured loans, then you need to adjust the rates for the collateral – which is your underlying asset. Or, maybe you took the rates offered to companies with low credit risk, but your credit profile is worse – then you need to adjust.

Finally, let me point out the materiality.

It can happen that you have just a few leases and thus the impact of these adjustments to observable rates would not be material. In this case, just take the observable rates and don’t bother with adjustments – they would be costly, judgmental and immaterial. But, you need to make absolutely sure that you are below your materiality level.

Lessee initial recognition and measurement

• Leases are ‘capitalised’ by recognising the present value of the lease payments and showing them either as right-of-use assets or together with property, plant and equipment.
• At commencement of the lease, record a right of use asset and a lease liability.
• The lease liability is measured at the present value of the future lease payments (fewer incentives)
• A lessee would also record a right of use asset at the amount of the lease liability, adjusted for:
  •  any initial direct costs (incurred by the lessee in arranging the lease)
  •  prepayments made by the lessee to the lessor
  • any lease incentives received from the lessor
  • and finally, if applicable, an estimate of costs to be incurred by the lessee to dismantle or remove or restore an asset (or the site on which the asset is located) at the end of the lease term

*IFRS 16 has two optional recognition exemptions – one for short term leases and one for leases of low value assets.

For Example: Year One – Beginning of Lease

Lessee enters into a 10-year lease of property with annual lease payments of $ 50,000 payable at the beginning of each year. The contract specifies that lease payments will increase every two years in line with the increase in the Consumer Price Index for the preceding 24 months.

The Consumer Price Index (CPI) at the commencement date is 125.

The lessee has determined the appropriate rate to discount lease payments is 5%. At the commencement date, the lessee makes the lease payment for the first year and measures the lease liability at the present value of the remaining nine payments of $ 50,000, discounted at the interest rate of 5% per annum, which is $ 355,391.

Lessee initially recognises assets and liabilities in relation to the lease as follows:

Dr Right-of-use asset $ 405,391

Cr Lease liability $ 355,391

Cr Cash $ 50,000 (lease payment for the first year)

In measuring the lease liability, the lessee does not make any estimate of how future changes in CPI will impact future lease payments. Rather it assumes the initial lease payment will remain constant during the lease term.

Disclosure:

The standard notes that more information may be necessary on:

• the nature of the lessee’s leasing activities;
• future cash outflows to which the lessee is potentially exposed that are not reflected in the
• Measurement of lease liabilities.
• restrictions or covenants imposed by leases;
• Sale and leaseback transactions.

– Ms. Krina Shah

• Till 2000, the budget was presented at 5pm on the last working day of February. It was only in 2001 that finance minister Yashwant Sinha changed the practice and the budget began to be introduced at 11am. It is believed that 5pm was the earlier preferred time as it was convenient for the British Parliament (as it was morning for them).
• The Union Budget of India has been conventionally tabled in Lok Sabha on the last working day of February up until 2016. From 2017 onwards, the Union Budget has been presented on February 1 following the changes brought up by former FM Arun Jaitley.
• The first Indian budget ever was presented by James Wilson, a Scottish economist and politician. He did so as a ‘Finance Member of the India Council’. He was reportedly tasked with establishing a new tax structure in India as well as a new paper currency. However, the most interesting thing about Wilson is that he established The Economist, the weekly magazine which today has a circulation of over a million. Wilson started it as a newspaper.
• Until 2016, Railway Budget was presented separately for about 92 years. Later in 2016, former Finance Minister Arun Jaitley amalgamated the Railway Budget with the Union Budget following which in 2017, the Railway Budget was presented along with the Union Budget. 
• The longest budget speech was delivered by finance minister Arun Jaitley in 2014. It was two and a half hours long and included a five-minute break.
• The maximum number of budgets have been presented by Morarji Desai. He presented the budget every year from 1959 to 1963. His second spree was from 1967 to 1969. Apart from this, he presented the interim budget for 1962-63 and 1967-68.
• On July 5, Nirmala Sitharaman become the second woman to have presented a budget. The first was Indira Gandhi in 1970-71.
• Before the budget finally goes to print, a ceremony is held in the ministry of finance, which is known as ‘the halwa ceremony’. Halwa, a traditional dessert is prepared and distributed to the staff of the ministry. It is after this that the printing of the budget, a very confidential operation, begins.
• Every budget is important but few in the history of modern India come close to former Prime Minister Manmohan Singh’s budget of 1991 in which India’s economy was liberalized.

#CorporateDebt #RatingsDowngrade #VodafoneIdea #AGR #MutualFunds #SidePocket

Recently Franklin India Ultra Short Bond Fund had written off its entire exposure in Vodafone Idea debt security (~4.3%) on increasing concerns of a possible default (due to supreme court rejecting the plea to reconsider its judgement regarding Adjusted Gross Revenue (AGR) related payments for telecom companies). This led to a one day fall of 4.3% in its NAV!

What Triggered the Mark Down of Vodafone Idea Debt?

This development is largely in lieu of the financial strain that telecom companies such as Vodafone Idea Limited have been going through given their enhanced financial liability. As per the fund house ‘Pursuant to the Honorable Supreme Court (SC) decision on the interpretation of Adjusted Gross Revenue (AGR) for computation of license fee, the financial liabilities of several telecom operators including VIL stand increased significantly. A review petition was filed by VIL before the SC on account of the fast approaching deadline of January 23, 2020 to discharge the dues, and the SC dismissed the review petition on January 16, 2020.’ As per the news reports, with this decision, VIL has admitted its inability to retain financial solvency in the absence of relief measures, given the huge quantum of AGR dues which they are required to pay immediately. Because of the uncertainty arising in the light of the ongoing scenario in case of VIL, the fund house took the decision to proactively mark down its exposure in the debt securities of the company.

Why is Franklin Templeton Not Side Pocketing VIL exposure in it’s schemes?

This could raise a question as to why the fund house didn’t side pocket VIL exposure. And the answer to that is that there has not been any rating action yet on this security, which as of now carries an investment grade rating of either CRISIL BBB- or CARE BBB-. A security can be side pocketed in case of a downgrade to a rating below investment grade.

The Purpose of Proactively Marking Down the Security

As per the fund house, the idea is to protect existing unitholders interest. Infact, the valuation adjustment here only reflects the realisable price of the relevant securities on the date of valuation and does not indicate any reduction or write-off of the amount repayable by VIL.

Moreover, fresh inflows in the schemes having exposure to VIL have been limited to INR 2 lacs per day per fund per investor, till further notice. This limit is imposed only on the new applications received after the cut-off time on 16^th January 2020. This is to ensure that the interest of existing unitholders does not get diluted to a large extent in case of debt recovery form VIL.

What is Side-Pocketing?

“Side Pocketing” is a mechanism to separate distressed, illiquid and hard-to-value assets from other more liquid assets in a portfolio. This prevents distressed assets from adversely affecting the returns of the rest of the portfolio. It has been introduced by the regulator (SEBI) to safeguard the interests of small/ retail investors in debt mutual funds.

How does this work?

Side-pocketing involves separation of the mutual fund portfolio into main portfolio and segregated portfolio in case of a credit event (for example, a bond in the mutual fund portfolio is downgraded to below investment grade by any of the rating agencies like CRISIL, ICRA, etc. leading to a drop in the NAV)

To understand this with an example, consider a mutual fund where an investor holds 100 units at NAV of INR 20 (portfolio value INR 2,000).

• One bond in the mutual fund portfolio, which was earlier contributing INR 3 to the NAV, is downgraded and now contributes INR 2 to the NAV. Hence the investor’s portfolio value has dropped from INR 2,000 to INR 1,900
• The AMC now separates the downgraded bond into the segregated portfolio and the rest remains in the main portfolio
• Consequently, the investor will get 100 units each in both portfolios. Main portfolio will have NAV of INR 17 and segregated/ side pocketed portfolio has NAV of INR 2
• Hence investor portfolio value does not change: Main portfolio = INR 1,700 and segregated/ side pocketed portfolio = INR 200
• All buying and selling is allowed only in the main portfolio
• Investors cannot freely redeem the segregated portfolio with the AMC and will get back the money sitting here only when AMC is able to recover the money from the bond issuing company

Does it help you?

Remember that it is not just you, the retail investor, who is investing in debt mutual funds. Many debt mutual fund categories see a lot of investment from institutional investors (Investment of Crores of Rupees!!).

Over the past several months, credit events have led to some debt mutual funds witnessing a sharp single day fall in NAV. This leads to large redemption in these funds led by institutional investors. The fund manager is forced to sell good quality investments in the portfolio to meet the redemption. Retail investors in these funds are then left with a portfolio that has a higher concentration of the downgraded/ lower quality bond.

With side-pocketing in place, all investors on the day of the credit event will be treated the same as no investment/ redemption will be allowed until side-pocketing is completed.

Has any AMC implemented this?

At present, SEBI has not mandated AMCs to implement side-pocketing but has left it to the discretion of the AMCs.  TATA AMC has introduced side-pocketing in most of their debt and hybrid schemes with effect from 15th June 2019. DHFL Pramerica MF has introduced side-pocketing in two of their Fixed Maturity Plans (FMPs). It remains to be seen if more AMCs will follow suit.

Short Video on this: